CEOs are dumb when it comes to this

SimonConstable

Just because you run a large and sophisticated public corporation doesn’t mean you can’t be played for a fool when it comes to executive pay.

It’s hard not to draw such a conclusion after reading a recently published study of CEO pay which cited extreme naiveté, confusion and knee-jerk decision-making.

Academics Kelly Shue and Richard Townsend of the University of Chicago and Dartmouth College, respectively, studied executive pay at corporations in the S&P 500 between 1992 and 2010. What they found is somewhere between jaw dropping and staggering.

The central issue is the way many corporations treat the value of executive stock options.

Stock options give the holder the right, but not the obligation, to purchase a predetermined number of shares at a predetermined price for a fixed period. As most people in finance know, the dollar value of an option is determined by a standard formula — the Black Scholes model.

The value of an option grant is in large part determined by the price of the company shares. If a stock rises 40% in one year then a similar-sized option grant will be worth 40% more. Authors Shue and Townsend explain all this and more in their April paper “Growth through Rigidity: An Explanation for the Rise in CEO Pay.”

But apparently, the people doling out the options to the executives either didn’t understand or chose to ignore this. Typically that’s the board of directors headed by the chairman who is often also the CEO.

The study found that by far the most common outcome was for corporate bigwigs to get exactly the same number of options as they did the previous year regardless of the dollar value, the report states.

That meant that in the roaring 1990s as the stock market soared so did the value of the option awards — because the executives and the people governing them most commonly ignored the dollar value of those awards.

To avoid such occurrences, compensation experts (and I know because I was such an expert for years) determine the dollar value of options they want to award first and then derive the number of options from that. If the stock price falls or rises it should mean more or fewer options are awarded each year.

Lucy Marcus, CEO of Marcus Venture Consulting, and an expert in corporate governance, puts her finger on it: “My question is why do you [the CEO] use common sense in everything else but throw that out of the window when it comes to your pay?”

The result of this practice was: “Option compensation [in dollars] grew more than sixfold over this period [1992 to 2001],” the authors say, while other executive pay remained “relatively flat.” Total pay jumped threefold in the same period. It’s remained pretty flat since, the authors found — in line with a relatively sideways market.

So how was it that people who generally consider themselves smart (CEOs and their boards) could be so off-target when it comes to compensation?

Or to rephrase: The corporate staffs and their advisers don’t understand the difference between the number of options and their value, and they are making it up as they go along.

“This is not right, the only way around it is to bring real transparency to it so everyone knows what’s going on,” says Marcus.

If you are looking for some Schadenfreude, you are in luck. The report authors also found that when the company had a 2-for-1 stock split, a surprisingly large number (more than 5%) of CEOs got the same number of options. In other words, those unlucky CEOs had their stock option pay cut in two.

“These results suggest a rather extreme form of naiveté regarding options,” the authors wrote. Or more simply, naiveté can cost you big time.

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